Sometimes you own a stock and its price suddenly drops... It just happens, and sooner or later it will happen to you too if you start investing in stocks.

For instance on Thu Sept 19 2013, $BBRY, was worth $10,50 in the morning, at the market opening, at the same time on the following day Fri Sept 20 2013, the stock price was $8.25. This is a 21% decline in 24 hours! In this situations you most likely as a retail investor will not have the time to close your position before it is too late, and PANG! You are then stuck with a trading loss.

For the purpose of our example, let us say that you had bought 100 shares of Blackbberry ($BBRY) a few weeks ago, on Sept 16th. The share price was then at $10.30. And you have then been hit by a pretty serious decline in the share price, as shown in the diagram below taken from Google Finance.

A sharp trading loss

The share price declined of $2.36 per share in the time period that we consider, so since we assume that you own 100 shares, you then have now a loss of $236.00. And actually your Profit/Loss (P/L) position depending on the future price of the $BBRY share can be well be represented by the following diagram:

So the questions you probably asked yourself is: what should I do? First you must understand that if the stock fell so much it is most likely not going back to the original level in the near future. On the other hand it might go back mid-way to a slightly higher level than where it fell during the brutal the big drop. For $BBRY you can it can plausibly come back quickly to $9.00-$9.50.

Some people try to buy more of the falling stock, thinking "if the stock went down so much it is becoming dirt cheap, it will bounce back up tomorrow so I can buy more from it, in order to I can cover my losses". That is not a good idea. Here a few reasons against this:

If the stock starts to go down, the big mutual funds which are the investors that actually decide the price of the stock, might start selling it to close their position in the stock. And this will definitely push the stock further down.

You increase your risk by buying more shares so you are becoming like a gambler in the casino, playing roulette or poker thinking that you want to risk more.

Buying a few Call Options instead of the stock itself is even a worse thing to do. Because you not only increase your risk but also are buying options which are overpriced since the volatility in the stock price has probably exploded overnight.

Stock repairing with Call Options

What if we told you that you can recover all your losses if the stock goes back only to $9.40, and that at the same time you would not be increasing your risk level? Would that sound too good to be true? The trick is to go into a stock-repairing strategy:

Buy a Call Option with a strike price at the current price of the stock

Sell two Call Options at a higher strike price

The diagram below taken from public data shows the option prices for the ist of options maturing in Dec2013. As you can see in the diagram, the cost of entering the position is minimal. For our example we will do the following

First, we buy a 8CALL, which is a Call Option with a strike price at the current price level of $8.00, for $65.00

And at the same time we sell two 10CALL, which are Call Options at a higher strike price of $10.00, for $18.00

What about the payoffs at maturity of the options?

First, you still have your 100 shares. And their payoff is still the same as we saw before:

Then you are long a 8CALL, a position that has the following payoff diagram if I include the Option Premium of $65 that you have paid:

Finally also are short two 10CALLs, which gives a position which as the following payoff diagram, if I include the $18 premium that you have received:

Now let us sum all these positions: 100 shares + long a 8CALL + short two 10CALLs. The result is the green curve in the diagram below, plotted against the yellow curve before the "repairing" strategy:

As you can see the new position gives you:- on the upside a much higher return than the 100 shares position. Which means that you do not need a full recovery of the stock price to fully recover your losses!- on the down side, virtually the same return as if you had kept your 100 shares. Which means that you do not increase your risk !

To wrap it up: recover your loss if the stock reaches only $9.4

Based on our simulation here as the different possible P/L that you will have at maturity of the options, depending on the final stock price in Dec 2013. You can see that you will have fully recovered all your losses if the stock goes back to a level of $9.4-$9.5 which is much lower than the original $10.3 at which you had bought the stock in the first place.

That my friends is a great strategy to use if you know or feel that a stock downturn was much too heavy and violent to be rightly priced. A correction will most likely be effective in the coming weeks, which will help your recover your loss.Want to learn more about stock repairing strategies and how they are implemented by professional option traders? Check this article from the Chicago Board Options Exchange (CBOE).